Fund pitch investing 101

Investing 101

Last time I attempted to go a bit socratic on you guys and see if we could teach valuations from first

principles, which I suppose could work in the right context but given that I’m not even Greek it wasn’t

exactly likely to succeed.

This is just to give you an idea of the alternatives, where someone literally reads word for word what’s

on the frickin slide….

Fun yeh?

Pretend I gave you £1 million

Pretend I gave you £1 million

• What would you do with it?

Pretend I gave you £1 million

• What would you do with it?Make some money• Aim to make money – how much?

Pretend I gave you £1 million

• What would you do with it?Make some money• Aim to make money – how much?Beat the risk free rate• To make it more realistic, pretend I loaned you

some money – why would I do that?

Pretend I gave you £1 million

• What would you do with it?Make some money• Aim to make money – how much?Beat your CAC• To make it more realistic, pretend I loaned you

some money – why would I do that?Because I think you can make more than the ‘risk free’ amount I gain in a bank.

What do you do with the money?

• In a world without stock exchanges.

What do you do with the money?

• Invest it in companies – what are the 2 ways?

What do you do with the money?

• Invest it in companies – what are the 2 ways?

• Shares

• Debt

• What is that?

What do you do with the money?

• Invest it in companies – what are the 2 ways?

• SharesBuy shares in the company – you own a percentage of that company.• DebtLend money to that company – you ‘own’ an obligation from the company to repay that debt.

What do you do with the money?

• Invest it in companies – what are the 2 ways?

• Shares - EquityA ‘share’ in the company. • Debt - BondsThat obligation is a bond.

How do you decide which?

What do you do with the money?

• Invest it in companies – what are the 2 ways?

• Shares – Equity - StockMore upside• Debt – Bonds - LoanLess downside

So how do you make money?

• Lets take the bond.

• Where do we make money?

So how do you make money?

• Lets take the bond.

• Where do we make money?Interest payments – the ‘coupon’.

So how do you make money?

• Lets take the bond.

• Where do we make money?Interest payments – the ‘coupon’.

Therefore Bond price = S (Interest) + loan repay.

Loan repayment is ‘the principal’ (amount of the loan).

But what about last week?

• The yield is the percentage return – eg. Coupon/price = yield.

• That formula works for everything – eg. The yield on a share is the return/price = % yield

But what about last week?

• The yield is the percentage return – eg. Coupon/price = yield.

• So, what if I tell you the coupon is fixed, and the price of the bond can float.

But what about last week?

• The yield is the percentage return – eg. Coupon/price = yield.

• So, what if I tell you the coupon is fixed, and the price of the bond can float.

• Therefore the yield can change.

But what about last week?

• The yield is the percentage return – eg. Coupon/price = yield.

• So, what if I tell you the coupon is fixed, and the price of the bond can float.

• Therefore the yield can change.

• When people price bonds, they talk about the yield not the coupon: so bond price is inverse to yield.

Now why does the price change?

• What is a bond?

Now why does the price change?

• What is a bond?

• An obligation to repay – but what if I can’t repay?

Now why does the price change?

• What is a bond?

• An obligation to repay – but what if I can’t repay?

Adverse credit rating changes reduce the price

• It’s a source of income – but what if someone else is offering bonds with better yield?

Now why does the price change?

• What is a bond?

• An obligation to repay – but what if I can’t repay?Adverse credit rating changes reduce the price

• It’s a source of income – but what if someone else is offering bonds with better yield?

I’ll sell my bond to buy the other one, push price down

So how do we make money?

So how do we make money?

• Either hold it to perpetuity and take the yield

So how do we make money?

• Either hold it to perpetuity and take the yield

• Or, you trade off that volatility by buying and selling early – credit conditions, market appetite etc.

So how do we make money?

• Either hold it to perpetuity and take the yield

• Or, you trade off that volatility by buying and selling early – credit conditions, market appetite etc.

So, equity…

• Can we use the same mechanism to make money?

So, equity…

• Remember, we’re in a world without stock exchanges (for now) – every company is private.

• How do we make money from investing?

• Can we use the same model?

Equity ‘yield’

• What’s the yield?

Equity ‘yield’

• What’s the yield?

• Dividends.

• Company total equity price =

Equity ‘yield’

• What’s the yield?

• Dividends.

• Company value = S ( dividends)

Now, a bit of reality – public stocks?

• Does anyone know the percentage dividend return for most stocks these days?

Now, a bit of reality – public stocks?

• Does anyone know the percentage dividend return for most stocks these days?

• People clearly aren’t assuming they will hold it to perpetuity – ie. The total price is not the sum of the forecasted dividends.

• So why such a high price?

Now, a bit of reality – public stocks?

• Upside. Growth.

What’s the difference between bonds and equity?

• Upside. Growth.

• Bonds are fixed (that’s why fixed income – FICC).

• Equity is …

What’s the difference between bonds and equity?

• Bonds are fixed (that’s why fixed income – FICC).

• Equity is variable, it can increase in value (whereas the bond Terminal Value will always be the principal).

What’s the difference between bonds and equity?

• So what you’re paying for is essentially the potential for your dividend stream to increase in the future.

• Why would that happen?

What’s the difference between bonds and equity?

• So what you’re paying for is essentially the potential for your dividend stream to increase in the future.

• Why would that happen?Just making more profit.Internal efficiency or External market improvements.

What’s the difference between bonds and equity?

• So what you’re paying for is essentially the potential for your dividend stream to increase in the future.

• Hence why dividends are so low…..

What’s the difference between bonds and equity?

• So what you’re paying for is essentially the potential for your dividend stream to increase in the future.

• Hence why dividends are so low…..

• If most of the price is potential for future growth, why give out cash when you could keep it to help growth?

What’s the difference between bonds and equity?

• The price is a forward indicator. You pay the sum of the future expected dividends.

• Obviously this relies on historic data, but the ‘price’ isn’t actually related to past data but the possibilities for the future.

What’s the difference between bonds and equity?

• Say I’m the Greed line (mapping dividends per year Y against time on the X axis).

• My price is higher than Red line. I would never sell to him.

What’s the difference between bonds and equity?

• But now we add the blue line.

• I would sell to the blue line, as he would value it more than I.

Stock pricing

• The market for a public stock is essentially determined by the supply and demand for that stock.

• So the price is the aggregate expected dividend return for the stock in the future.

Stock pricing

• This leads to the Efficient Market Hypothesis.

• Essentially, if we are all acting rationally, then the stock price should reflect the true price (as the aggregate of all available information), and there should be no way to profit from stock prices (without insider information).

Stock pricing

• This leads to the Efficient Market Hypothesis.

• But: 1: Hayek

Stock pricing

• This leads to the Efficient Market Hypothesis.

• But: 1: HayekWe do not all have perfect information, nor the cognitive abilities to process that much information.

Stock pricing

• This leads to the Efficient Market Hypothesis.

• But: 1: HayekWe do not all have perfect information, nor the cognitive abilities to process that much information.• But 2: price is forward looking.

Stock pricing

• This leads to the Efficient Market Hypothesis.

• But: 1: HayekWe do not all have perfect information, nor the cognitive abilities to process that much information.• But 2: price is forward looking.We cannot predict with accuracy the future. So really, there is no way of predicting the actual fair value for a stock (unless you know the entire company’s earnings over it’s full lifetime).

Stock pricing

• So lets take stock (pun intended)…

Stock pricing

• So lets take stock (pun intended)…

• Prices are forward looking, and we can’t predict the future, thus we cannot actually know the ‘true’ price for a stock.

• As an aside – this is particularly relevant if you consider Venture Capital.

VC aside

• Normal pricing relies somewhat on extrapolation to guess at future returns – impossible for early stage companies with no track record.

VC aside

• Normal pricing relies somewhat on extrapolation to guess at future returns – impossible for early stage companies with no track record.

• Even if you have a proxy for another company that followed your target’s footsteps, most VC backed startups fundamentally reshape industries.

Eg. iPhone

• Pretend the iPhone is launching.

• How would you estimate the final company value?

Eg. iPhone

• Pretend the iPhone is launching.

• How would you estimate the final company value?

Other smartphones? Phones in general? PC’s?

Eg. iPhone

• Pretend the iPhone is launching.

• How would you estimate the final company value?Other smartphones? Phones in general? PC’s?

• The answer is you couldn’t – the iPhone fundamentally reshaped the industry in such a way that it simply wasn’t predictable.

Eg. iPhone

• Pretend the iPhone is launching.

• How would you estimate the final company value?Other smartphones? Phones in general? PC’s?

• The answer is you couldn’t – the iPhone fundamentally reshaped the industry in such a way that it simply wasn’t predictable.

• Credit to Benedict Evans of Andreesen for the example – this dude’s amazing if you want a blog to follow.

Stock pricing

• So lets take stock (pun intended)…

• Prices are forward looking, and we can’t predict the future, thus we cannot actually know the ‘true’ price for a stock.

• So what do you do?

Stock pricing

• So lets take stock (pun intended)…

• Prices are forward looking, and we can’t predict the future, thus we cannot actually know the ‘true’ price for a stock.

• So what do you do?You stop worrying…..

Stock pricing

• You aren’t going to hold your stock to perpetuity (possibly unlike a PE or VC investor).

• What matters is what you can sell it for.

Stock pricing

• You aren’t going to hold your stock to perpetuity (possibly unlike a PE or VC investor).

• What matters is what you can sell it for.

• What matters is what everyone else thinks, not the ‘truth’. Hence the best hedge fund guys are really psychologists more than Economists.

Stock pricing

• So you think about how people think about a stock.

Stock pricing

• So you think about how people think about a stock.

• Stocks aren’t really thought of as actual equity. I don’t want to own some of the company, I just want the stock price to go up in value.

Stock pricing

• So you think about how people think about a stock.

• People don’t think of stock as equity, they think of it as one way of betting on that companies future.

• Hence why there are so many other contracts that people use other than actual equity.

Other financial instruments

• Short selling (not exactly an instrument)• Swaps• Options• Contracts for difference• ETF• …

Enter the Quants.

• So, if a stock isn’t really a company, but a probability, enter your math geeks.

Enter the Quants.

• So, if a stock isn’t really a company, but a probability, enter your math geeks.

• Eg. CAPM

Enter the Quants.

• So, if a stock isn’t really a company, but a probability, enter your math geeks.

• Eg. CAPM

• Ra = Rf + B (Rm – Rf).Return of the stock = Risk free rate of return + Beta (return of market – Risk free rate)

Enter the Quants.

• CAPM: Ra = Rf + B (Rm – Rf).Return of the stock = Risk free rate of return + Beta (return of market – Risk free rate)

• Essentially, you balance risk against reward (that’s your optimization problem when you get there in Quants for the econ people).

Enter the Quants.

• CAPM: Ra = Rf + B (Rm – Rf).Return of the stock = Risk free rate of return + Beta (return of market – Risk free rate)

• You have to pay me for extra ‘risk’ (defined as the possibility of your returns differing from your expected returns).

Enter the Quants.

• CAPM: Ra = Rf + B (Rm – Rf).Return of the stock = Risk free rate of return + Beta (return of market – Risk free rate)

• Hence, if I’m logical, I would only buy a stock rather than a risk free asset like a treasury bill (a US gvt bond) if my extra risk was compensated with extra return.

Enter the Quants.

• CAPM: Ra = Rf + B (Rm – Rf).Return of the stock = Risk free rate of return + Beta (return of market – Risk free rate)

• Return of the market is the total index return (ie. The weighted total of all the stocks in a group – like the FTSE 100 index).

• The difference between this, and the risk free rate, is a proxy for the extra return that people are seeking to make up for the extra risk of that equity.

Enter the Quants.

• CAPM: Ra = Rf + B (Rm – Rf).Return of the stock = Risk free rate of return + Beta (return of market – Risk free rate)

• Beta is how your stock moves relative to the market.

• So, the extra risk premium for your particular stock, is the extra risk premium for the market as a whole, multiplied by how your stock moves relative to that market.

Confusing?

Confusing?

• Just a little bit.

• It’s also wrong – or at least, it’s not a magic formula for how much a stock is worth.

• Unless it is – how could that happen?

Confusing?

• Just a little bit.

• It’s also wrong – or at least, it’s not a magic formula for how much a stock is worth.

• Unless it is – how could that happen?What if everyone in the world used CAPM?

Why there are so many ways to value a stock

• So last week I went through three ways (Discounted Cash Flow, Comparisons with peer companies, and breakup value)

• The problem, is that you can’t know the ‘true’ value, so we have lots of different measures and it’s up to you to put them together and come to your own view.

So, pretend I gave you £1 million

• What would you do with it?

• We’ll be having a running competition, so get thinking….

Appendix – last week

Intro to Investing

Tom Williams

How much is something worth?

How much is a company worth then?

So what does that actually mean?

So how does that help me?

- Public stock?- Private company?

Appendix

Tesla

Tesla – 12.03.15

Tesla

Tesla

Preview

Vehicle world

The best car ever

Revenues

Cost of sales and R&D

Balance Sheet

Liabilities

Cash Flows

Cash flows

Stockholders equity

Metrics

CFROI etc…

So, as a car company…

But

Lithium ion batteries

Batteries in the grid

More on batteries

Apple play?

The smell of success (Musk)

Conclusions

• Do not buy as a car maker• Maybe buy for the battery / grid potential?

• What happens if Musk dies tomorrow?

Side note, the dudehas like photoshop on his face…

Visa and that…

Analysis of payments industry

Approach

• Consider industry as a whole• Analyse individual companies strategy within

that area (good financials are a measurement of the past, strategy indicates future)

• Analyse company financials (good management is pointless if it’s already priced in)

Financials

Financials

Financials

Financials

Cash Flow

Backup

Established players – Acquirers• Visa / Mastercard

– Do not issue cards. Create network: Bank/Credit co – V/MC – Merchant.

• American Express / Discover– Do issue their own cards. Do all payment processing themselves.

• Japan Credit Bureau, China UnionPay

• Primary aim: More total volume on their network = more fees– Greater consumption = more transactions– Fewer cash / cheque = more transactions– More people on their networks – either reduce costs or add value

• Secondary aim: Reduce costs– Current fees:– Potential from:

• Secondary aim: Add value:

• Disintermediation: Someone else linking up the banks without using cards.• Emerging markets:

Visa

Mastercard

New entrants – Tech giants

• Apple• Google• Microsoft?

New entrants – Phone companies

New entrants – social media

• Facebook• Twitter